Skip to main content

Full text of "Description of enterprise zone proposals (H.R. 6 and administration proposal) : scheduled for hearings before the House Committee on Ways and Means on October 17-18, 1989"

See other formats


DESCRIPTION OF ENTERPRISE 

ZONE PROPOSALS 

(H.R. 6 AND ADMINISTRATION PROPOSAL) 

Scheduled for Hearings 

BEFORE THE 

HOUSE COMMITTEE ON WAYS AND MEANS 
ON OCTOBER 17-18, 1989 



Prepared by the Staff 

OF THE 

JOINT COMMITTEE ON TAXATION 




OCTOBER 14, 1989 



U.S. GOVERNMENT PRINTING OFFICE 

WASHINGTON : 1989 JCS-16-89 



For sale by the Superintendent of Documents, U.S. Government Printing Office 
Washington, DC 20402 



O 

x: 

x: 
u 

x: 
5 



o^ 


^ 


00 


CT) 


1 


rH 


vo 




H 


QJ 


1 


4J 


V3 


o 


U 


c 


»-3 


-U 




o 


« 


o 


g 


U-l 




T3 


-a: 


OJ 


M 


Cl4 


ic£ 


D4 


K 


O 


2 


u 


W 


T> 




O 




fl4 




O 



vo 



(U 




en 


• • 


03 


UJ 


D4 


5 




O 


C 


iH 


O 


rH 




O 




U-l 




if) 




nj 



W 


03 




P m TJ 






O (U O 


M M 




•H -H 


dJ Q) 




> - M 


^ > > 




(U -U OJ 


0)0 




u-l M -H a >i 


■H 




x: o DjTJ X) 14-1 m m 




U QJ (U 


•H 4-» dJ 




H QJ Q) H U) T3 rH Oj-H 




(U CP OJ U 03 QJ 


03 -H 03 




OJ 03 M X3 4J 


P OJ Ul 




Ul U x: QJ 03 


tr u 




0) 0) 4J x: ^M 


dJ dJ 




M> 4->cr\:3M-iMCP 




03 0) a> u 


03 




T3 x: M-l CN rH 


in u 




O ui -U O f^ 03 


O V) <D 




•H - U 


•H O > 




Ui M M C • 


4-) M 03 




QJ 0) 0) O flj Q) 


03 CP 




Dj >i > H .X) 


V-i >i 




03 o ui m 


O X) 




OJ Cb C TJ 


dJ -U 




en X t/i dJ c rH 


Cr T3 




03 03 (U -»J -H ::3 


03 U5 O 




X) -M M M O 


M dJ -H 




:3 0) (1) 5 


dJ M W4 




- OJ -P Ul 


> :3 dJ 




5 x: -H dj d u) 


03 -P Qi 




03 -M TJ x: O 0) 


•H 




rH d -U m VI 


dJ TJ d; 


• 


rH (u c x; c tn 


Ul 


4-» 03 p^ M a; Q) 


-P d) 03 


M 


C P X Q) x: Pj 


ax) 


03 


(U tr (1) T) 4J X 


CP X 


d) 


U Q) d OJ 


C (DXi 


>i 


M T) D >i 


•H d) 




7:3 V) d) X) x: 


>ix: 4J 


U) 


U Q) -H U rH U 03 


d 


U) u-l . r^ M 


a M c 


o 


U C -H CO CU 03 


•H 03 CP 


H 


dJ 0) rH V-i to 0) 


4J dJ -rH 


> 


T> Cii 03 03 tn ui 


rH cn c/1 


dJ 


c X :3 0) 03 dJ 


::j d) dJ 


V-< 


D d) tr >i Oi M 


e >-• T3 


Cb 



CT^ 



CONTENTS 



Page 

Introduction 1 

I. Summary 2 

II. Present Law 5 

III. Description of H.R. 6 10 

IV. Administration Proposal 17 

V. Issues Relating to Tax Incentives for Enterprise 

Zones 19 



(III) 



INTRODUCTION 

The House Committee on Ways and Means has scheduled pubUc 
hearings on October 17-18, 1989, on proposals relating to enterprise 
zone tax incentives: H.R. 6 (The Enterprise Zone Improvements Act 
of 1989, introduced by Mr. Rangel and others) and the Administra- 
tion's proposal. 

This document, ^ prepared by the staff of the Joint Committee on 
Taxation, provides a description of the enterprise zone proposals. 
Part I is a summary. Part II is a brief description of related 
present-law provisions. Part III is a description of the provisions of 
H.R. 6, and Part IV is a summary description of the Administra- 
tion proposal. Part V discusses issues related to tax incentives for 
enterprise zones. 



1 This document may be cited as follows: Description of Enterprise Zone Proposals (H.R. 6 and 
Administration Proposal) (JCS-16-89), October 14, 1989. 

(1) 



I. SUMMARY 

Present Law 
Tax incentive provisions 

Targeted area 

The Internal Revenue Code does not contain general rules for 
targeting areas for special tax treatment. Within certain Code sec- 
tions, however, there are definitions of targeted areas for limited 
purposes. For example, the provisions relating to qualified mort- 
gage bonds define targeted areas for the purpose of promoting 
housing development within economically distressed areas. 

Tax credits for employers 

There are no general provisions in present law under which an 
employer's tax liability varies according to the location of its em- 
ployees. The targeted jobs tax credit in present law does, however, 
provide a targeted jobs tax credit for a portion of wage payments 
made to certain groups of employees. 

Investment tax credit 

An investment tax credit is allowed under present law for quali- 
fied rehabilitation of structures: 20 percent for rehabilitation of a 
certified historic structure and 10 percent for rehabilitation of a 
building originally placed in service before 1936. 

Under prior law, a 10-percent investment tax credit applied to el- 
igible tangible personal property used in a trade or business or for 
the production of income. The basis of the property was reduced by 
one-half of the amount of the credit. 

Capital gains 

Net capital gains are taxed as ordinary income under present 
law. Before 1987, net gains from the sale or exchange of a capital 
asset were taxable at a reduced rate. Noncorporate taxpayers could 
reduce net capital gains by 60 percent, and the remainder was 
taxed as ordinary income — effectively establishing a maximum 20- 
percent rate. The maximum tax rate for corporate capital gains 
was 28 percent. 

Private activity bonds 

Although interest on State or local government bonds used to fi- 
nance trade or business activity generally is taxable, various excep- 
tions are provided for what are termed private activity bonds. 
These include bonds issued as qualified small-issue bonds, as quali- 
fied redevelopment bonds, or to finance certain other private activi- 
ties. Issuance of private activity bonds generally is subject to State 
volume limitations. 

(2) 



Non-tax provisions 

Foreign trade zones 

A foreign trade zone may be established within any port of entry. 
Duties are not levied on imported goods shipped into a foreign 
trade zone until and unless such goods are sent into other United 
States territory. 

Regulatory flexibility 

Present law provides that certain regulatory procedures be al- 
lowed in order to ease the regulatory burden on small businesses, 
small nonprofit organizations, and small governmental jurisdic- 
tions. 

Summary of H.R. 6 
Designation of enterprise zones 

The bill would apply with respect to any area designated as an 
enterprise zone under the Housing and Community Development 
Act of 1987, including any area designated before the date of the 
enactment of H.R. 6. 

Tax incentive provisions 

Employment tax credits 

The bill would provide a tax credit to employers for enterprise 
zone employment. The amount of the credit would be equal to the 
sum of two amounts: (1) 10 percent of the qualified increase in an 
employer's employment expenditures and (2) the applicable eco- 
nomically disadvantaged credit amount for the employee. 

In addition, the bill would provide a tax credit to qualified em- 
ployees of 5 percent of qualified wages. 

Investment tax credit 

The bill would allow an investment tax credit of 10 percent for 
new enterprise zone construction property. 

Capital gains 

The bill would provide that gains on sale of property would not 
be recognized if the taxpayer used the proceeds within 12 months 
to acquire enterprise zone property. 

Deduction for purchase of stock 

The bill would provide a deduction of up to $100,000 annually per 
taxpayer for the purchase of newly issued stock in qualifying corpo- 
rations. 

Private activity bonds 
The bill would repeal the present-law sunset date applicable to 
qualified small-issue bonds and would allow accelerated cost recov- 
ery methods to be used instead of straight-line depreciation for 
property financed with private activity bonds for use in designated 
zones. The bill also would expand the definition of qualified small- 



issue bonds to permit tax-exempt financing of facilities engaged in 
activities other than manufacturing. 

Research credit 

The bill would provide a research credit for research conducted 
in an enterprise zone of 37.5 percent. 

Tax simplification 

The bill contains a Sense of the Congress resolution that would 
require the Secretary of the Treasury to simplify administration 
and enforcement of Code provisions amended by the bill. 

Effective date 

The bill generally would be effective after December 31, 1988, 

Summary of Administration Proposal 

The Administration's enterprise zone proposal includes three tax 
incentives applicable to qualifying investments and employees in 
50 enterprise zones. The proposal provides a 5-percent refundable 
tax credit to employees with total wages less than $20,000 for the 
first $10,500 of wages earned in an enterprise zone. Taxpayers may 
deduct up to $50,000 annually, with a lifetime maximum of 
$250,000, for purchases of qualifying newly issued stock in qualify- 
ing corporations. Any capital gain realized on qualifying assets 
during zone designation periods would be excludible from taxable 
income. Designation of qualifying enterprise zones would occur in 
phases: 15 in 1990; 15 more in 1991; 15 more in 1992; and 5 more in 
1993. 



II. PRESENT LAW 

Fax incentive provisions 

Targeted area 

The Internal Revenue Code does not contain general rules for 
;argeting specific geographic areas for special tax treatment. 
A'^ithin certain Code sections, however, there are definitions of tar- 
geted areas for limited purposes. For example, the provisions relat- 
ng to qualified mortgage bonds define targeted areas for the pur- 
pose of promoting housing development within economically dis- 
;ressed areas. Within such areas, which are defined on the basis of 
;he income of area residents or the general economic conditions in 
;hese areas, rules for the financing of owner-occupied homes with 
jualified mortgage bonds are less restrictive than the generally ap- 
Dlicable rules. 

Tax credits for employers 

Under present law, the tax liability of an employer does not vary 
)ased on where an employee performs services on behalf of the em- 
aloyer. The targeted jobs tax credit under present law provides a 
:ax credit for a portion of the wages paid to individuals froni nine 
:argeted groups. These groups generally are defined according to 
:he individual's physical condition, participation in a specified edu- 
:ation or rehabilitation program, or economic status. 

The credit generally is equal to 40 percent of the first $6,000 of 
iiualified first-year wages paid to a member of a targeted group, for 
a maximum credit of $2,400. The employer's deduction for wages 
must be reduced by the amount of the credit claimed. The credit is 
:urrently scheduled to expire after December 31, 1989. ^ 

Tax credits for employees 
Under present law, the tax liability of an employee does not vary 
based on where the employee perform services in the United States 
on behalf of the employer. However, an eligible individual who 
maintains a home for one or more children is allowed an advance 
refundable tax credit based on the earned income of the individual. 
For 1989, the earned income tax credit equals 14 percent of the 
first $6,500 of earned income. The credit is phased out if adjusted 
gross income (or, if greater, earned income) exceeds $10,240. 

Tax credits for investments 
An income tax credit is allowed under present law for certain ex- 
penditures incurred in rehabilitating certified historic structures 
and certain nonresidential buildings placed in service before 19db. 

2 H.R. 3299 (as passed by the House on October 5, 1989) would extend the expiration date by 
two years to December 31, 1991. 

(5) 



The credit rate is 20 percent for expenditures incurred in rehabili 
tating certified historic structures and 10 percent for expenditures 
incurred in rehabilitating buildings originally placed in service 
before 1936. The basis of any building with respect to which the rt 
habilitation credit is claimed is reduced by the full amount of the 
credit. 

Before 1986, a 10-percent investment tax credit was allowed foi 
the cost of eligible tangible personal property that was used in a 
trade or business or for the production of income. The basis of the 
property was reduced by one-half of the amount of the credit. The 
investment tax credit was not allowed with respect to real proper- 
ty. 

Expensing of certain investments 

There is no provision under present law that allows the amount 
of an investment to be expensed {i.e., deducted for the year in 
which the investment occurs) based on the location of the invest- 
ment. Present law, however, provides that in lieu of a depreciation 
deduction, a taxpayer (other than an estate or trust) may elect to 
deduct all or a portion of the cost of qualifying property for the 
taxable year in which the property is placed in service. The maxi- 
mum amount that may be expensed under this provision for any 
taxable year is $10,000. In general, qualifying property is any tan- 
gible personal property that is predominantly used in the active 
conduct of a trade or business. 

Nonrecognition provisions \ 

A sale or exchange of an asset generally is a taxable event. How- 
ever, in a number of instances, gain or loss realized by a taxpayer i 
upon the sale or exchange of an asset is not recognized for Federal I 
income tax purposes. For example, no gain or loss is recognized if 
property held for productive use in a taxpayer's trade or business, 
or property held for investment purposes, is exchanged solely for 
property of a like-kind that also is to be held for productive use in 
a trade or business or for investment (sec. 1031). As another exam- 
ple, a taxpayer generally may defer recognition of gain on the sale 
of a principal residence if the sales price of the old residence is re- 
invested in a new principal residence within a specified period of | 
tirne (sec. 1034). Present law does not provide for nonrecognition of 
gain or loss in the case of a sale or exchange of an asset that is 
located within a particular economically distressed area. 

Capital gains 

Net capital gains are taxed as ordinary income under present 
law.3 Before 1987, net capital gains were taxed at a reduced rate. 
All taxpayers other than corporations could reduce net capital 
gains by 60 percent, and the remainder was taxed as ordinary 
income— effectively establishing a maximum 20 percent rate. The 
net capital gains tax rate for corporations was 28 percent. Capital 



' H.R. 3299 (as passed by the House on October 5, 1989) would provide a 30 percent exclusion 
from income for gains realized after September 14, 1989, and before January 1, 1992, on assets 
held longer than twelve months. Commencing in 1992, gains would be indexed for inflation and 
a maximum tax rate on capital gains of 28 percent would be imposed. 



assets generally include any property held by the taxpayer with 
the exception of property used, or held for sale, in the taxpayer's 
trade or business. This reduction in tax was treated as a preference 
item for purposes of the minimum tax. 

Private activity bonds 

Although interest on State or local government bonds used to fi- 
nance trade or business activity generally is taxable, various excep- 
tions are provided. For example, interest on State or local govern- 
ment bonds is tax-exempt if the bonds are qualified small-issue 
(used to finance manufacturing facilities or property acquired by 
first-time farmers) bonds or qualified redevelopment bonds. Tax- 
exempt private activity bonds issued by States and local govern- 
ments generally are subject to State volume limitations.'* In addi- 
tion, the depreciation deduction for property financed with tax- 
exempt bonds generally is determined by using the straight-line 
method over the class life of the property. 

Losses with respect to certain securities 

The loss resulting from the worthlessness of a stock, bond, or 
other evidence of indebtedness issued by a corporation is generally 
treated as a loss from the sale or exchange of a capital asset. Con- 
sequently, the loss is subject to the general rules that limit the 
amount of capital losses that may be allowed as a deduction for 
any taxable year. 

If an individual incurs a loss with respect to certain small busi- 
ness stock, the loss is treated as an ordinary loss rather than a cap- 
ital loss. The maximum amount that may be treated as an ordi- 
nary loss for any year under this provision is limited to $50,000 
($100,000 in the case of a husband and wife who file a joint return). 

Research credit 

A 20-percent tax credit is allowed for the amount of qualified re- 
search expenses paid or incurred by a taxpayer during a taxable 
year that exceeds the average amount of the taxpayer's yearly 
qualified research expenses in the base period (generally, the pre- 
ceding three taxable years). The credit also applies to certain pay- 
ments to universities for basic research.^ 

Non-tax provisions 

Designation of Enterprise Zones under the Housing and Com- 
munity Development Act of 1987 

Pursuant to the Housing and Community Development Act of 
1987, the Secretary of Housing and Urban Development (HUD) 
may designate not more than 100 nominated areas as enterprise 
zones (42 U.S.C sec. 11501 et seq).^ An area may be so designated 



* Under current law, the authority to issue qualified small-issue bonds expires after December 
31, 1989. H.R. 3299 (£is passed by the House on October 5, 1989) would extend this expiration 
date to December 31, 1991. 

^ Under present law, the research credit is scheduled to expire after December 31, 1989. How- 
ever, H.R. 3299 (as passed by the House on October 5, 1989) would permanently extend the re- 
search credit, with modifications. 

^ HUD has received 270 nominations of areas seeking to be designated as enterprise zones as 
of the January, 1989 deadline. Thus far, none of the nominated areas has been so designated. 



8 

after being nominated by one of more local governments and the 
State or States in which it is located, and after the Secretary of 
HUD consults with the Secretaries of Agriculture, Commerce, 
Labor, and the Treasury, the Director of the Office of Management 
and Budget, and the Administrator of the Small Business Adminis- 
tration, and, in the case of an area on an Indian reservation, the 
Secretary of Interior. An enterprise zone designation shall remain 
in effect for twenty-four years (or until an earlier termination date 
designated by the State or local government, or until the designa- 
tion is revoked by the Secretary of HUD). 

A nominated area may be designated as an enterprise zone only 
if it meets the following requirements: (1) the boundary of the area 
is continuous; (2) the area has a population of not less than 4,000 if 
any portion of the area (excluding certain qualifying rural areas) is; 
located within a metropolitan statistical area with a population of 
50,000 or more; and (3) the area's population is at least 1,000, or the 
area is entirely within an Indian reservation. In addition, the State 
and local governments (or Indian reservation governing body) must 
certify, and the Secretary of HUD must accept such certification, 
that (1) the area is one of pervasive poverty, unemployment, and 
general distress; (2) the area is located wholly within the jurisdic-j 
tion of a local government that is eligible for Federal assistance 
under section 119 of the Housing and Community Development Act 
of 1974; (3) the unemployment rate is at least 1.5 times the national 
unemployment rate; (4) the poverty rate within the area is at least 
20 percent; and (5) either (a) at least 70 percent of the households 
in the area have incomes below 80 percent of the median income of 
the local government, or (b) the population of the area decreased by 
20 percent or more between 1970 and 1980 (42 U.S.C. sec. 11501(c)). 

At least one-third of the enterprise zones must be within rural! 
areas, meaning such areas (1) are within a local government 
jurisdiction(s) with a population of less than 50,000, (2) are outside | 
of a metropolitan statistical area, or (3) are determined by the Sec- 
retary of HUD, after consultation with the Secretary of Commerce, 
to be rural areas (42 U.S.C. sec. 1 1501(a)(2)(B)). ^ ' 

The Secretary of HUD shall designate nominated areas with the 
highest average ranking with respect to certain criteria reflecting 
the areas' unemployment and poverty rates and any decrease in 
population (42 U.S.C. sec. 11501(a)(3)). 

No area shall be designated as an enterprise zone unless the 
local government and the State (or, in the case of a nominated area 
on an Indian reservation, the reservation governing body) in which 
the area is located agree in writing that, during any period during 
which the area is an enterprise zone, such governments will follow 
a specified course of action designed to reduce the various burdens 
borne by employers or employees in such area, including, but not 
limited to, (1) a reduction of tax rates or fees applying within the 
area; (2) an increase in the level of public services, or in the effi- 
ciency of the delivery of public services, within the area; (3) actions 



A rural area may be designated as an enterprise zone only if it is certified as being an area 
of pervasive poverty, unemployment, and general distress; but such a rural area need not satisfy 
all of the specific criteria which a non-rural area must satisfy to be designated an enterprise 
zone (42 U.S.C. sec. 11501(c)(4)). 



to reduce or simplify paperwork requirements within the area; (4) 
program involvement by public authorities, private entities, organi- 
zations, neighborhood associations and community groups, particu- 
larly those within the area (including a commitment to provide 
jobs and job training for, and technical, financial, and other assist- 
ance to, employers, employees and residents of the area); (5) the 
giving of special preference to contractors owned and operated by 
minorities; and (6) the gift of surplus land in the area to neighbor- 
hood organizations agreeing to operate a business on the land (42 
U.S.C. sec. 11501(d)). 

Foreign trade zones 

A foreign trade zone may be established within any port of entry. 
Duties are not levied on imported goods shipped into a foreign 
trade zone until the goods are removed to a location in the United 
States that is not a foreign trade zone. 



III. DESCRIPTION OF H.R. 6 

Designation of enterprise zones 

The provisions of H.R. 6 would apply with respect to any area 
designated as an enterprise zone under the Housing and Communi- 
ty Development Act of 1987, including any area designated before 
the date of the enactment of H.R. 6. 

Employer tax credit for certain enterprise zone employment 

In general 

The bill would provide a tax credit to employers for enterprise 
zone employment. The amount of the credit would be equal to the 
sum of two amounts: (1) 10 percent of the qualified increase in an 
employer's employment expenditures; and (2) the applicable eco- 
nomically disadvantaged credit amount for the employee. 

The computation would be made on a taxable year basis and 
would allow for 3-year carrybacks and 15-year carryforwards of 
unused credits. The credit could not reduce the amount of regular 
tax (after application of certain credits) in any year below the ten- 
tative alternative minimum tax. No deduction would be permitted 
for wages equal to the amount of credit provided. 

If an enterprise zone's designation is revoked under section 
701(b)(2) of the Enterprise Zone Act, the zone would be treated as a 
designated zone for purposes of the credit for the next three years, 
except that the amount of allowable credit would be reduced.® In 
the first year following revocation 75 percent of the credit would be 
allowed; in the second year 50 percent would be allowed; and in the 
third year 25 percent would be allowed. 

Qualified increase in employment expenditures 

A credit equal to 10 percent of the qualified increased employ- 
ment expenditures would be permitted. The amount of qualified 
wages paid by an employer in designated enterprise zones during a 
specified 12-month period, which exceeded the qualified wages paid 
by that same employer during the immediately preceding 12-month 
period, would be eligible. 

To be "qualified wages" for purposes of this credit, wages would 
have to meet the definition of wages currently in the code for 
(FUTA) employment tax purposes, with some modifications. One 
modification would exclude any Federally funded payments the 
employer received or accrued for on-the-job training. A second dif- 
ference would relate to special rules for agricultural and railway 
labor. In no event, however, could qualified wages with respect to 
any employee exceed 2.5 times the wage base for FUTA taxes. (Cur- 



* H.R. 6 refers to the Enterprise Zone Act. This reference appears to be to Title VII of the 
Housing and Community Development Act of 1987, Public Law 100-242. 

(10) 



11 

rently, the FUTA wage base is $7,000.) The bill also would provide 
that wages could not be taken into account for this credit if they 
otherwise are taken into account in calculating the economically 
disadvantaged credit, described below. 

A phaseout of the credit percentage for qualified increased em- 
ployment expenditures would be provided. For a taxable year 21 
years after the date on which an enterprise zone received designa- 
tion as such, or for a taxable year 4 years before the date on which 
a zone ceases to be a zone under section 701(b)(1)(B) of the Enter- 
prise Zone Act, the percentage would be reduced from 10 percent to 
7.5 percent. The credit in the following year would be 5 percent, 
the succeeding year 2.5 percent, and zero percent for all succeeding 
years thereafter. 

Economically disadvantaged credit 

The second element of the credit computation would be the eco- 
nomically disadvantaged credit amount which would represent the 
sum of the applicable percentage of qualified wages paid to each 
qualified economically disadvantaged individual. Qualified wages 
are defined as above, except that there is no limitation on the 
amount of wages that would qualify. 

The term "qualified economically disadvantaged individual" 
would be defined as an individual who possessed each of three 
qualifications. First, the individual would have to be a "qualified 
employee". Second, the individual would have to be hired by an 
employer in a currently designated area and would have to per- 
form services for that employer in that designated area. Third, the 
individual would have to be certified as either (1) an economically 
disadvantaged individual, (2) an eligible work incentive employee, 
or (3) a general assistance recipient. (This certification would be 
made in a manner similar to that under the targeted jobs credit. 
(Code sec. 51).) For purposes of this credit, an economically disad- 
vantaged individual would be a member of a family with income 
(including the cash value of food stamps) during the preceding 6 
month period that was no more than the amount which could be 
paid to a family with no income of the same size as the individual's 
under the State's aid to family with dependent children program 
plus the highest cash value of food stamps for which such family 
could be eligible. 

In addition, an employee for whom the employer claimed the tar- 
geted jobs tax credit would not be considered a "qualified employ- 
ee". 

The applicable percentage for the credit would be determined by 
the following table: 



12 

Qualifled wages paid for services performed during the period Applicable 

after the starting date percentage 

First 3 years 50 

4th year 40 

5th year 30 

6th year 20 

7th through 20th year 10 

21st year or later 



The starting date would be the day the which the qualified eco- 
nomically disadvantaged individuals begins work for the employer 
within an enterprise zone. 

Effective date 

The employer credit would be effective for taxable years begin- 
ning after December 31, 1988. 

Tax credit for enterprise zone employees 

In general 

A tax credit of 5 percent of qualified wages would be granted to 
qualified employees. The credit could not reduce the employee's 
regular tax (after application of certain credits) below the tentative 
alternative minimum tax. 

A qualified employee is defined as above, i.e., at least 90 percent 
of the services of the employee during the taxable year must be di- 
rectly related to the conduct of an employer's trade or business lo- 
cated in the enterprise zone, and at least 50 percent of the services 
must be performed for the employer within the enterprise zone. An 
employee of the Federal Government or any State or local govern- 
ment would not qualify for these purposes. 

Qualified wages are defined as FUTA wages for services to an 
employer for whom the employee is a qualified employee. Wages 
for purposes of this credit cannot exceed 1.5 times the FUTA wage 
base limitation, currently $7,000. 

In a manner similar to the portion of the employer credit for 
qualified increased employment expenditures, the credit percentage 
for the employee credit is phased out 21 years after the enterprise 
zone received such designation or 4 years before termination. In 
the year following the year specified above, the percentage would 
be 3.75 percent; the next succeeding year the percentage would be 
2.5 percent; the second next succeeding year the percentage would 
be 1.25 percent; and in all following years the percentage would be 
zero. 

Effective date 

The employee credit would be effective for taxable years after 
December 31, 1989. 



13 

Investment tax credit for certain enterprise zone property 

In general 

Under the bill, a 10-percent investment tax credit would be al- 
lowed for investments in certain real property (including lodging) 
that is located in an enterprise zone if the property is acquired or 
constructed by the taxpayer and the property is used predominant- 
ly by the taxpayer in the active conduct of a trade or business (in- 
cluding the rental of real estate) within the enterprise zone. 

In the case of property acquired by the taxpayer, the credit 
would be allowed only if the property is acquired during the period 
that the enterprise zone designation is in effect and only if the 
original use of the property commences with the taxpayer. In the 
case of property constructed, reconstructed, rehabilitated, renovat- 
ed, expanded, or erected by the taxpayer, the credit would be al- 
lowed only with respect to the portion of the basis of the property 
that is attributable to construction that occurs during the period 
that the enterprise zone designation is in effect. 

The credit would not be allowed with respect to property that is 
acquired directly or indirectly from a person who is related to the 
taxpayer. In addition, the credit rate would be reduced by 25 per- 
cent for property placed in service during the year that includes 
the date that is 21 years after the enterprise zone designation and 
by an additional 25 percent for each year thereafter. 

The basis of any property with respect to which an enterprise 
zone investment tax credit is allowed would be reduced by the full 
amount of the credit. 

Recapture 

If property with respect to which an enterprise zone investment 
tax credit was claimed is disposed of, a portion of the credit would 
be recaptured (i.e., the amount of tax for the year of disposition 
would be increased). The amount of the credit subject to recapture 
would equal the difference between the full amount of the credit 
allowed for the property and a recomputed credit based on the 
amount of time that the property was held by the taxpayer. The 
recomputed credit would bear the same ratio to the amount of the 
credit originally allowed as the number of taxable years during 
which the property was held by the taxpayer bears to the number 
of years in the recovery period of the property for purposes of com- 
puting earnings and profits. 

Effective date 

The enterprise zone investment tax credit generally would be 
available for periods beginning after December 31, 1988. 

Capital gains 

In general 

If the taxpayer sold or exchanged any property and within 
twelve months used the proceeds to purchase qualified enterprise 
zone property, the bill would permit the taxpayer to elect nonrec- 



14 

ognition treatment of the gain on this sale or exchange.^ The bill 
defines qualified enterprise zone property as any tangible personal 
property used predominantly by the taxpayer in his business 
within a designated enterprise zone or any real property located 
within the zone and used by the taxpayer in his business. Qualified 
enterprise zone property would also include interests in a corpora- 
tion, partnership, or other entity if for the three years prior to pur- 
chase of the interest, the entity was a qualified enterprise zone 
business. ^° 

If the taxpayer elected nonrecognition treatment, he or she 
would be required to adjust the basis of the new property down- 
ward by the amount of the gain not recognized. Similarly, the hold- 
ing period of the new property would be measured from the date of 
acquisition of the property on which the gain was not recognized. 

The election of nonrecognition of gain would not apply to any 
purchase of stock for which the taxpayer elected to deduct from 
income the aggregate value of the stock at the time of the purchase 
of the stock. ^ ^ 

Effective date 

The bill would apply to sales or exchanges of qualifying assets 
after December 31, 1988. 

Deduction for the purchase of enterprise stock 

In general 

The bill would permit a taxpayer, at his election, to deduct from 
taxable income up to $100,000 annually for the purchase of qualify- 
ing stock in a qualifying enterprise zone corporation.^^ If the elec- 
tion is made, the taxpayer's basis in such stock is reduced by the 
amount of deduction claimed. Any gain on the subsequent sale of 
such stock is treated as ordinary income. The taxpayer and all per- 
sons related to the taxpayer are counted as one for purposes of ap- 
plying the $100,000 limitation. If the taxpayer purchases more than 
$100,000 of qualifying stock in any year, the deduction is distribut- 
ed pro rata across the stock purchased. 

The original issue of stock, the proceeds of whicii are to be used 
in the conduct of a qualified enterprise zone business, constitutes 
qualifying stock. Qualifying enterprise zone corporations are those 
corporations which conduct a qualified enterprise zone business 
and do not at the time of issuance of the stock have a net worth in 
excess of $2 million. In addition, to be a qualifying corporation, the 
corporation must not for the five years beginning with the issuance 



* The election of nonrecognition treatment applies to gains only, not to losses. 

'°The bill defines a "qualified business" as one actively engaged in the conduct of a trade or 
business within an enterprise zone during each of the three preceding taxable years. In addition, 
such business must have generated at least 80 percent of its gross receipts from activities car- 
ried on vvithin the zone, and have substantially all of its tangible assets located within the zone. 
Ownership of residential, commercial, or industrial real property within a zone would qualify as 
conduct of an active trade or business within the zone. 

' ' See the discussion below on deductions for purchase of enterprise stock. 

' ^ Amounts paid after the close of the taxable year for the purchase of qualifying stock would 
be eligible for the deduction if the amount was paid not later than the time prescribed for filing 
the taxpayer's return for the taxable year for which the deduction was being claimed, or if the 
taxpayer was under a binding contract as of the close of the taxable year to purchase qualifying 
stock. 



15 

of the qualifying stock have any outstanding securities which are 
registered on a national exchange, ^^ or are registered under sec- 
tion 12(g) (without regard to section 12(g)(2)) of the Securities Ex- 
change Act of 1934.^'' Further, during the five-year period begin- 
ning with the issuance of the qualifying stock, not more than 50 
percent of the gross receipts of the corporation can arise from roy- 
alties, rents, '^ dividends, interest, annuities, and sales and ex- 
changes of stock or other securities. 

If, within three years, the taxpayer disposes of any enterprise 
zone stock on which he elected a deduction, the taxpayer must in- 
clude in his income an enterprise stock recapture amount. The en- 
terprise stock recapture amount is the amount of interest which 
would have accrued on the tax saved by the taxpayer at the time of 
purchase of the securities by reason of the deduction. In addition, 
should the issuer cease to be qualified at any time during the five 
years following the issue of the securities, the taxpayer must in- 
clude in his income the amount claimed as a deduction at the time 
of purchase of the securities plus the amount of interest which 
would have accrued on the tax saved by the taxpayer at the time of 
purchase of the securities by reason of the deduction.^® 

Effective date 

The bill would apply to purchases of qualifying stock after De- 
cember 31, 1988. 

Private activity bonds 

Present law establishes a sunset date of December 31, 1989 for 
the issuance of qualified small issue manufacturing facility 
bonds. ^' The bill would revoke the sunset date as it applies to 
qualified small issue bonds for facilities located within enterprise 
zones. Moreover, the bill would permit tax-exempt financing of en- 
terprise zone facilities engaged in activities other than the manu- 
facturing or production of tangible personal property. 

The bill would permit qualified enterprise zone property that 
was financed with the proceeds of tax-exempt bonds to use the ac- 
celerated cost recovery system which would apply in the absence of 
tax-exempt financing. Current law requires an alternative system 
of straight-line cost recovery over a longer recovery period for prop- 
erty financed with tax-exempt bonds. 

Effective date — The bill would apply to bonds issued after Decem- 
ber 31, 1988. 



•' As provided under section 12(b) of the Securities Exchange Act of 1934. 

'■' For purposes of satisfying the net worth and five-year tests, the issuer and all persons relat- 
ed to the issuer are treated as one person 

' * Other than rents of those qualifying zone businesses whose business is the rental of real 
estate, as discussed above. 

'* It appears to be an unintended consequence that, under the bill, a taxpayer who purchased 
qualifying stock in year one and sold it in year four, would be subject to this recapture provision 
if the corporation ceased to qualify in year five, even though the taxpayer no longer held the 
stock. 

" The Omnibus Budget Reconciliation Act of 1989 (H.R. 3299, as passed by the House on Oc- 
tober f), 1989) would extend the authorization of qualified small issue IDBs to bonds issued 
before January 1, 1992. 



16 

Research credit 

Under the bill, a 37.5-percent credit would apply to the amount 
of qualified research expenditures incurred by a taxpayer during a 
taxable year for research conducted in enterprise zones that ex- 
ceeds base period qualified research expenses conducted in enter- 
prise zones. ^^' ^^ An area would be treated as an enterprise zone 
for a base period with respect to a taxable year if such area is des- 
ignated as an enterprise zone for such taxable year. 

Effective date — The enhanced research credit for research con- 
ducted in enterprise zones would apply to taxable years beginning 
after December 31, 1988. 

Tax simplification 

The bill contains a Sense of the Congress resolution that would 
urge the Secretary of the Treasury to simplify administration and 
enforcement of Code provisions amended by the bill. 



'* The amount of enterprise zone qualified research expenses for which the 37.5 percent credit 
would apply could not exceed the amount by which the taxpayer's total qualified research ex- 
penses (for research conducted within and without enterprise zones) for a taxable year exceeded 
the taxpayer's total yearly qualified research expenses (for research conducted within and with- 
out enterprise zones) in the base period. 



IV. ADMINISTRATION PROPOSAL 20 
Designation of enterprise zones 

Under the Administration's enterprise zone proposal, 50 zones 
would be designated over a four-year period — 15 in 1990, 15 more 
in 1991, 15 more in 1992, and 5 more in 1993. The President's pro- 
posal provides that the characteristics of the enterprise zones 
would be consistent with the distress requirements applicable to 
the designation of enterprise zones under the Housing and Commu- 
nity Development Act of 1987. 

Refundable wage credit for low-income zone employees 

The Administration proposal would provide a 5-percent refund- 
able tax credit for the first $10,500 of wages paid to an individual 
working in an enterprise zone and having total wages below 
$20,000.21 The maximum credit is $525, and the credit is phased 
out between $20,000 and $25,000 of total wages. 

Expensing of investor purchases of small zone corporate stock 

Under the Administration proposal, investors could deduct cur- 
rently ("expense") investment in newly issued corporate stock of 
qualified small subchapter C corporations. Expensing would be 
available for investments in corporations having less than $5 mil- 
lion of total assets, so long as the investments coincide with compa- 
rable increases in the corporation's tangible zone assets. Substan- 
tially all the activity of qualified corporations must be located in 
designated enterprise zones. 

The deduction for the purchase of qualifying newly issued stock 
would be available up to $50,000 annually per individual taxpayer, 
with a $250,000 lifetime limit. These deductions reduce the inves- 
tor's basis in the stock, Consequently, any gain attributable to ex- 
pensed stock would be taxable at ordinary rates. Amounts ex- 
pensed would be subject to existing Code limitations, including the 
alternative minimum tax. The proposal intends that the deduction 
not be combined with other tax subsidies such that a tax subsidy of 
more than 100 percent results. 

Zero capital gains tax rate on tangible zone assets 

The Administration proposal would exclude from taxable income 
any capital gain realized during zone designation periods on quali- 
fied assets. Qualified assets must be tangible assets, located in 
zones, and used in qualified businesses that have operated in zones 
for at least two years prior to gain realization. 



20 As described in a letter from President Bush to Chairman Rostenkowski, dated July 25, 
1989. 

21 While it is not clear in the letter to Chairman Rostenkowski, the intent appears to be that 
the credit be refundable to the employee. 

(17) 



18 

Gains qualifying for exemption must accrue after zone designa- 
tion and before termination of the designation. Assets already lo- 
cated in a zone must be appraised at the time of zone designation, 
as must existing assets relocated into zones following designation. 
All qualified assets must be appraised at the termination of zone 
designation. 

Effective date 

The proposal would be effective after December 31, 1989.^2 



2 2 Except for the provision to phase in the designation of qualifying zones, it is not clear in 
the letter to Chairman Rostenkowski what effective dates are intended to apply to the other 
provisions. The intent appears to be that the various provisions be effective after December 31, 
1989. 



V. ISSUES RELATING TO TAX INCENTIVES FOR 
ENTERPRISE ZONES 

Overview of issues 

The effect of tax incentives on the location of investments 

At the heart of the enterprise zone proposals (both H.R. 6 and 
the Administration proposal) is the belief that economic incentives 
presented through the Internal Revenue Code can redirect invest- 
ment toward economically disadvantaged areas. Research on the 
impact of State and local tax factors on the location decisions of 
firms is inconclusive. On the one hand, lower local property taxes 
or lower State or local income taxes act directly to lower the cost of 
doing business in a particular area. This could make low tax juris- 
dictions relatively attractive to businesses. On the other hand, rela- 
tively high tax jurisdictions may provide higher quality public serv- 
ices and are often associated with highly educated and/or highly 
skilled local labor forces. These factors could offset the higher tax 
cost of doing business in a high tax jurisdiction. Separating out 
these conflicting forces is a difficult task and conclusive economet- 
ric evidence has not yet been provided on this issue. ^^ 

As an alternative methodological approach to this issue, a 
number of surveys have been undertaken to address the effective- 
ness of tax incentives on location decisions as well. Generally, these 
surveys explicitly ask managers of firms about the importance of 
financial factors on location decisions. For the most part, these sur- 
veys have found that governmentally provided financial incentives 
{e.g., low interest loans, property tax abatements, income tax cred- 
its) are of secondary importance to a firm's location decision. Pri- 
mary factors for location decisions included items like proximity to 
markets, availability of suitable raw materials and an appropriate- 
ly trained labor force, and access to transportation networks. Re- 
searchers hypothesize that primary factors attract a firm to a par- 
ticular geographic region and that secondary factors may affect the 
particular choice of location within that region. 2** However, many 
economists suggest caution in interpreting the findings of survey 
research since responses to survey questions may not accurately 
forecast the economic behavior of decision makers. 



2 3 For examples on both sides of the issue, see "Why New Firms Locate Where They Do: An 
Econometric Model", by Dennis Carlton, in Interregional Movements and Regional Growth (Wil- 
liam Wheaton, ed.), Urban Institute, 1979; and "Econometric Analysis of Business Tax Impacts 
on Industrial Location: What Do We Know and How Do We Know It?", by Robert Newman and 
Dennis Sullivan, Journal of Urban Economics, March 1988. 

2* Examples of survey research in this area include "The Location of Firms: The Role of 
Taxes and Fiscal Incentives", by Michael Wasylenko, in Urban Government Finance: Emerging 
Trends (Roy Bahl, ed.) Sage Publications, 1981; and "The Failure of Tax Concessions as Econom- 
ic Development Incentives", by Larry Ledebur and William Hamilton, in Reforming State Tax 
Systems (Steven Gold, ed.). National Conference of State Legislatures, 1986. 

(19) 



20 

Efficiency of tax incentives for enterprise zones 

If tax incentives can significantly affect the location decisions of 
firms, it is unclear whether the induced investment in enterprise 
zones constitutes net new investment to the nation that would oth- 
erwise not have been made or whether it is merely investment 
shifted from another locale. If investment in enterprise zones re- 
places investment that would have taken place elsewhere (for in- 
stance, if investment moves away from established centers of eco- 
nomic activity and toward designated enterprise zones), the pri- 
mary effect of the investment incentives would be redistributional. 
To the extent that investment in enterprise zones is investment 
which is redistributed from local labor markets with low unemploy- 
ment to local labor markets with high unemployment, the enter- 
prise zone programs may direct investment from expensive local 
labor markets to those with an excess of relatively less expensive, 
under-utilized labor. In this event, the enterprise zone programs 
may generate efficiency gains for the economy as under-utilized re- 
sources are tapped. 

In addition to providing incentives to locate existing businesses 
in particular geographical areas, the incentives could induce the 
creation of new businesses which would not otherwise have been 
initiated in any location. Such new businesses could produce tax- 
able profits and incomes which might reduce the revenue cost of 
the incentives. On the other hand, the incentives could induce in- 
vestments into enterprise zones which would be uneconomic in the 
absence of the tax incentives. Such an outcome would reduce the 
efficiency of aggregate national investment. 

If enterprise zones provide sufficient incentives to affect the loca- 
tion decisions of firms, an additional question is whether these in- 
centives are provided in a cost-effective manner. To be cost-effec- 
tive, the tax subsidies provided should be the smallest subsidies 
needed to achieve the desired behavioral change. Moreover, the 
subsidies should be narrowly targeted so that the benefits of these 
subsidies go primarily to firms that change their economic behav- 
ior in the desired fashion. That is, a cost-effective tax incentive pro- 
gram would minimize the amount of subsidy going to investors who 
would have located in the enterprise zone even in the absence of 
the tax subsidy program. Clear definitions of what areas constitute 
an enterprise zone for purposes of these tax incentive programs 
may aid in fashioning cost-effective tax subsidies. 

Neutrality 

Preferential treatment for employment and investment in enter- 
prise zones creates non-neutrality in employment and investment 
decisions. Non-neutralities can create an inefficient allocation of re- 
sources as it can be more profitable, on an after-tax basis, to locate 
property at site A rather than site B, even though on a pre-tax 
basis site B would produce greater pre-tax profits. On the other 
hand, such non-neutralities may be necessary to promote the social 
goal of more economic growth and opportunity in distressed areas. 



21 

Deferral v. exemption 

Proposals to provide tax incentives for enterprise zones generally 
provide certain forms of income deferral from tax or exemption 
from tax. Exempting income from taxation is always more valuable 
to the taxpayer than deferring taxation on the same income. For 
example, if $1,000 could be invested for 10 years to earn eight per- 
cent annually and those earnings were exempt from taxation, this 
investment would have accumulated $1,158.93 in interest by the 
end of the 10-year period. If the earnings instead were taxed annu- 
ally to a taxpayer at a 28-percent marginal tax rate, the accumu- 
lated interest, net of taxes, would be $750.71 after 10 years. If the 
earnings were not taxed annually, but rather the tax was deferred 
for 10 years and assessed on the accumulated interest at the end of 
the 10-year period, the value of the taxpayer's net earnings would 
be $834.43. In this example, deferral increases the taxpayer's 
return by 11.2 percent over the 10-year period compared to annual 
taxation. Exemption is 38.9 percent more beneficial than deferral 
over the same period. 

The benefit of tax exemption generally is greater to a higher- 
income taxpayer than a lower-income taxpayer, because the tax li- 
ability saved per dollar of tax-exempt income is greater for taxpay- 
ers in higher tax brackets. The benefit of deferral depends not only 
on the taxpayer's current tax rate, but also on his or her future tax 
rate. The benefit of deferral is increased for a taxpayer who cur- 
rently is taxed at a high marginal rate, but who can defer the tax 
liability until a lower marginal rate applies. The benefit of deferral 
is decreased if the taxpayer currently is taxed at a low marginal 
rate and defers the tax liability to a year when a higher marginal 
tax rate applies. In this circumstance, because of the taxpayer's 
low initial tax rate, the taxes deferred may actually be worth less 
than the taxes owed at the later date when the taxpayer is in a 
higher tax bracket. 

Equity considerations 

Equity issues are also raised by the proposed enterprise zone leg- 
islation. Horizontal equity would require that taxpayers in similar 
situations be treated by the tax system in the same manner. Verti- 
cal equity would require that taxes be assessed in line with the tax- 
payer's ability to pay. To the extent taxpayers with identical eco- 
nomic incomes bear different income tax burdens as a result of the 
enterprise zone tax incentive programs, the goal of horizontal 
equity is not attained. To the extent that the benefits of enterprise 
zone tax incentives accrue primarily to high income taxpayers, the 
vertical equity of the income tax system may be compromised. 

Tax incentives may be structured as either deductions or credits. 
When taxpayers face different marginal tax rates, deductions yield 
different dollar amounts of tax benefits depending upon the tax- 
payer's tax bracket. As the taxpayer's income and marginal tax 
rate increase the tax subsidy increases. Credits yield the same 
dollar of tax benefit to all recipients. ^^ 



2 5 This is not strictly true if the taxpayer has an insufficient tax liability to utilize the credit 
and the credit is not refundable. 



22 

Employer tax credit for enterprise zone employment 

The employer credits in H.R. 6 consist of two separate credits: a 
credit for increased employment and a credit for wages paid to the 
economically disadvantaged. 

Credit for increased employment expenditures 

The 10-percent credit for increased employment expenditures is 
intended as an incentive for the expansion of employment and 
wages beyond a base period level of wage expenditures. Because 
only wages below the designated cap (currently $17,500) would be 
eligible for the credit, the credit would provide an incentive for 
part-time or modestly compensated labor. For example, an increase 
in wages paid from $17,000 to $18,000 for additional work per- 
formed by a current employee would not be eligible for the credit, 
but hiring a part-time employee to do the same work for $1,000 
would generate wages eligible for the credit. 

The employer credit for increased employment expenditures is a 
marginal credit relative only to the amount of qualified wages paid 
by the employer prior to designation as an enterprise zone. In the 
case of a business that starts up after an area is designated as an 
enterprise zone, all qualified wages would be eligible for the credit 
every year. Also, if in later years the amount of employment and 
qualified wages decline from a previous higher level, the amount of 
wages paid in excess of the amount paid before the area was desig- 
nated an enterprise zone would still qualify for the credit. 

Credit for economically disadvantaged 

An additional amount of credit would be provided for wages paid 
to certain economically disadvantaged employees. The credit would 
be 50 percent of wages paid to these individuals for the first three 
years of employment, declining to zero percent after 20 years of 
employment. 

A 50-percent wage credit for all wages paid to certain individuals 
is likely to provide a strong incentive for employment of designated 
individuals. Some have expressed concern, however, that the 
amount of credit and length of time over which the credit may be 
obtained poorly targets the credit. It would be unnecessary, they 
argue, to provide a substantial credit to an employee who has sev- 
eral years of tenure with a business, regardless of the individual's 
previous background, in order for the employer to strive to retain 
that employee. Because it appears the determination of employee 
eligibility is made only once, the employee may no longer be eco- 
nomically disadvantaged and yet still be eligible for the economi- 
cally disadvantaged credit for an extended period of time. In addi- 
tion, there is no requirement that the employee reside within or 
near the enterprise zone. 

Others respond that because the background of economically dis- 
advantaged employees is sufficiently adverse, an employment in- 
centive is necessary over a long period of time to ensure their con- 
tinued employment. Also, they argue that employment and busi- 
ness activity within a zone will benefit the distressed area regard- 
less of where the employees reside. 



23 

Credit for employees 

Both the Administration proposal and H.R. 6 would provide a 5- 
percent credit to employees for some amount of enterprise zone 
wages. H.R. 6 would provide a credit for the first $10,500 of wages 
(based on the FUTA wage base) to employees whose service is di- 
rectly related to the conduct of a business in an enterprise zone; 
the Administration proposal has the same base but would reduce 
the credit amount to zero by $25,000 of wages and would be limited 
to employees working in an enterprise zone. 

Some argue that the credit would have the greatest effect on the 
distressed area if the employee were required to work in the enter- 
prise zone instead of only providing services "directly related" to a 
zone business, as provided in H.R. 6. Proponents claim, however, 
that it is necessary to provide incentives for businesses to establish 
operations within a zone, and this credit, on top of the employer 
credits, will encourage more employment within a zone regardless 
of where a particular employee is located. 

Some question the need to provide a credit to individuals who 
would otherwise be well compensated and argue that it is prudent 
to reduce the credit amount for individuals with compensation 
above a certain level, as is done in the Administration's proposal. 
Others maintain that new enterprise zone businesses require a mix 
of skill levels, and an incentive for individuals at all compensation 
levels to work in these areas is needed. 

Investment tax credit 

H.R. 6 would provide a 10-percent credit for depreciable real 
property invested in enterprise zones. The credit, unlike the invest- 
ment tax credit in the past, would be for depreciable real estate 
and not equipment. In the past, it has been argued that it was nec- 
essary to encourage investment in equipment, rather than real 
estate, as a means to encourage more productive business activi- 
ties. 

Supporters of the proposal point out that it would be necessary 
to build up the capital stock in enterprise zones, including the 
stock of housing. Depreciable real estate, because it is not movable, 
would have long-term benefits for the enterprise zone area that 
could not be provided by increased investment in movable equip- 
ment. 

Treatment of capital gains and purchases of enterprise zone stock 

Overview 

H.R. 6 and the Administration's proposal on enterprise zones 
would create preferential treatment for capital gains with respect 
to enterprise zone property. H.R. 6 would permit taxpayers to defer 
recognition of gain on any property sold if the proceeds were rein- 
vested in enterprise zone property. The Administration's proposal 
would exclude from taxable income any gain on qualifying enter- 
prise zone property. 

Both H.R. 6 and the Administration's proposal would create a de- 
duction for the purchase of qualifying stock in a qualifying enter- 
prise zone corporation. If the deduction is claimed, the taxpayer's 
basis in the stock must be reduced by the amount of deduction 



24 

claimed, and any subsequent gain is taxed as ordinary income. Con- 
sequently, the deduction for the purchase of stock would permit the 
taxpayer to defer any tax liability both on that portion of current 
income used to purchase the stock and on any price appreciation of 
that stock. 

Incentives for equity investments 

An argument for preferential capital gains tax rates for enter- 
prise zone property and deductions for purchases of enterprise zone 
stock is that they encourage investors to buy corporate stock in en- 
terprise zone businesses, and especially to provide venture capital 
for new companies, stimulating investment in productive business 
activities within the zone. 

Opponents of preferential capital gains treatment for zone assets 
argue that such preferences may create substantial windfalls for 
owners of existing enterprise zone property. Demand for such prop- 
erty is increased by a tax preference which is available only to 
property within a specified geographic location, thereby driving up 
its price. Opponents argue that such windfalls would do little to 
create new employment opportunities. To the extent that housing, 
and more generally, land are qualifying assets, the increased 
demand for these assets could drive up the cost of housing in desig- 
nated enterprise zones. 

Opponents also assert that a preferential tax rate for capital 
gains, even if targeted geographically, encourages taxpayers to 
enter into transactions designed to convert ordinary income into 
capital gains. Proponents counter that such "conversion" opportu- 
nities are simply an additional tax incentive for investments in en- 
terprise zones which the preference is intended to encourage. 

Opponents of preferential treatment for capital gains on zone 
property argue that a preferential tax rate on capital gains may be 
inefficient because the preference is available to investments which 
would have occurred without the preference as well as to net, new 
investments. Opponents also question the efficacy of a deduction 
for the purchase of stock in enterprise zone corporations. They note 
corporations routinely raise capital and that as a consequence the 
benefit of the deduction for purchases of corporate stock often may 
go to investors who would have purchased the stock without the de- 
duction. Proponents of the deduction for the purchase of zone stock 
respond that even when this occurs the deduction will have encour- 
aged equity investments rather than debt. 

Cost of capital 

Proponents of preferential treatment for capital gains for enter- 
prise zone property and deductions for the purchase of stock in en- 
terprise zone corporations argue that the cost of capital is high for 
enterprise zone investments. They argue that a preferential tax 
rate on capital gains increases investors' net returns in such assets 
and thereby will lower the cost of capital for such investments. In 
addition, proponents note, a deduction for the purchase of stock in 
an enterprise zone corporation makes such stock relatively more 
attractive than other assets and thereby lowers the cost of raising 
investment funds. With a relatively lower cost of capital, more in- 
vestment capital would flow into designated areas. 



25 

Opponents argue that because the preference for capital gains ac- 
crues only to property located in the enterprise zone, gains in re- 
duced capital costs may be offset by increases in land costs, as the 
demand for such land increases. In addition, opponents argue that 
because of the ability to defer gains, the ability to receive step-up 
of basis at death, and the substantial participation of tax-exempt 
institutions in the investment markets, the effective tax rate on 
gains, which helps determine the cost of capital, may be substan- 
tially below the statutory rate. For example, one recent study cal- 
culated that prior to 1987 the effective marginal tax rate on capital 
gains, including State taxes, was less than 6 percent. ^^ On the 
other hand, proponents of a capital gains tax reduction for enter- 
prise zone property contend that any reduction in a tax on capital 
may reduce the cost of capital for these investments. 

Incentives for risk-taking 

Proponents of preferential treatment argue that a reduced tax 
rate on gains encourages risk-taking, and that investors generally 
would view investments in designated zones as particularly risky. 
As a consequence, a preferential capital gains tax rate for enter- 
prise zone property is justified to overcome this outcome of the 
marketplace. In addition, it is argued, preferential treatment is im- 
portant for the entrepreneur who often contributes more in time 
and effort than in capital. Opponents argue that if risk-taking is to 
be encouraged, a more efficient method might be to reduce the cur- 
rent asymmetric treatment of gains and losses, by expanding the 
provisions for loss offset in a targeted manner. The financial gains 
from risk-taking and the creative process are the major rewards 
entrepreneurs seek. 

Length of preference period 

Creating a permanent preference for capital gains which occur 
on property in enterprise zones could bestow benefits on owners of 
assets long after the economic development of an enterprise zone 
has progressed to the point that such benefits are unnecessary. 
Permitting preferential treatment on gains accrued prior to enter- 
prise zone designation may reduce taxes without receiving com- 
mensurate employment or productivity growth in return. 

On the other hand, proposals which would grant preferential 
capital gains treatment only during a limited period, such as 
during the period of enterprise zone designation, would create in- 
centives to sell the enterprise zone property before the end of such 
period. This could reduce the attractiveness of enterprise zone in- 
vestments, thereby reducing the effectiveness of the preference. 
The incentive to realize gain prior to the expiration of the period of 
preferential treatment could reduce prices for enterprise zone 
assets and create instability in the market for such assets. Some 
argue that a preference for a limited period does not promote in- 
vestment with a long-term view, but rather creates a short-term, 
unstable investment environment. In addition, limiting the prefer- 
ence to gains which accrue during a specified period necessitates 



2* Don Fullerton, "The Indexation of Interest, Depreciation, and Capital Gains and Tax 
Reform in the United States," Journal of Public Economics, February 1987. 



26 

appraisals of enterprise zone assets at the beginning and end of the 
period. Such appraisals can be costly and create tax compliance dif- 
ficulties. 

Private activity bonds 

H.R. 6 would provide that property financed with tax-exempt en- 
terprise zone bonds be permitted accelerated cost recovery. This, in 
effect, creates an additional capital subsidy for investments in de- 
preciable property that is used in designated enterprise zone areas. 
Some question whether this added subsidy would act generally to 
provide the necessary incentive to overcome the drawbacks of lo- 
cating in an economically disadvantaged area or whether it simply 
would serve as a bonus payment for firms that would have under- 
taken these investments even in the absence of such a capital sub- 
sidy. 

The bill also provides for a permanent extension of the small- 
issue qualified bond sunset date of December 31, 1989 for bonds 
issued to finance investment in enterprise zones. If investors could 
be certain that future investments in enterprise zone property 
could be financed in a tax-exempt manner, they might be more 
likely to engage in a long-term planning process than if they be- 
lieved such financing would be available only for a limited period. 
Presumably, having a long time horizon would contribute to the 
probability of success of firms locating in enterprise zones. Howev- 
er, the provision of the implicit subsidy of tax-exempt finance for 
enterprise zone investments could result in financial savings to 
firms that would have undertaken the investments even in the ab- 
sence of such a capital subsidy. If this possibility was a major con- 
cern, then a temporary extension that would be reviewed periodi- 
cally might be a more desirable alternative. 

H.R. 6 would also permit tax-exempt financing of enterprise zone 
facilities engaged in activities other than the manufacturing or 
production of tangible personal property. This could broaden sub- 
stantially the types of facilities that could be financed using tax- 
exempt bonds. The scope of potential employment opportunities in 
enterprise zones would be broadened accordingly. 

Research credit 

Under H.R. 6, a 37.5-percent credit would be available to the tax- 
payer for the lesser of (1) the excess of current qualified expendi- 
tures over the base amount (the "general excess") or (2) this same 
excess if only enterprise-zone research is taken into account (the 
"enterprise-zone excess"). 

If the enterprise-zone excess is smaller than the general excess, 
increases in enterprise-zone expenditures would receive a 37.5-per- 
cent credit in addition to any general 20-percent research credit at- 
tributable to these expenditures. If the general excess is smaller 
than the enterprise-zone excess, general increases in expenditures 
oyer the general base would receive a 37.5-percent credit in addi- 
tion to the 20-percent credit available under the general credit. 

Under the proposal, base period amounts would not take into ac- 
count pre- 1989 enterprise-zone research in calculating the enter- 
prise-zone excess. If current law were extended, the taxpayer would 
have a zero base for calculating the enterprise-zone excess in 1989 



27 

and a favorable phased-in base for 1990 and 1991. If either the 
House of Representatives version or Senate Finance Committee 
version of the research credit became law, the enterprise-zone 
excess would presumably be calculated under the favorable treat- 
ment accorded start-up compani^. 

For a taxpayer with an enterprise-zone excess smaller than its 
general excess, the credit provides an incentive to increase enter- 
prise-zone research. On the other hand, much of the increase may 
result from relocation of research from areas that are not in enter- 
prise zones to enterprise zones. For a taxpayer with a general 
excess smaller than its enterprise-zone excess, the credit would pro- 
vide no special incentive for increasing research within an enter- 
prise zone. 

o